Friday, December 30, 2016

I love Roths!

They're probably one of my favorite things in the world so I'll start my blog talking about Roths.

Huge thanks to the late William V. Roth Jr., who was a Delaware senator, we now have this investment flavor called Roth.  He sponsored the legislation that would create Roth IRA.  We now also have a Roth 401(k) and Solo Roth 401(k).

What are these things you call Roths?

Glad you asked. Roth is a flavor of retirement accounts that means "contribute post-tax money now, withdraw them and their earnings tax-free later".

I am a huge fan just because when I look at my portfolio, I can say to myself that yeah, as long as I follow the withdrawal rules, all of what I see now (subject to possible losses of course) is mine and mine alone.  Uncle Sam can't take any of it.

With a traditional IRA or 401(k), while it's nice to see the funds accumulate there, I know that they won't all be mine at the end of the day.  As you may know, for traditional accounts, you contribute pre-tax money but when you withdraw them and their earnings, you will pay tax on them.  Well, there are also flavors of these traditional accounts where you contribute post-tax money.  However, the earnings for those will still be taxable.

Not to say you should ignore these traditional accounts.  I have them, too.  As with all things, it depends on your situation and personal preferences.  When you have the slightest doubt, please consult your tax accountant.

Contribution Limits for Roth IRA

Alas, not everything is sunshiny for Roth IRA.  The IRS imposes limits on how much you can contribute depending on your income.

These are the limits for 2017:  Roth IRA Contributions, straight from the horse's mouth.

If it's past 2017 now, you should be able to find the similar page for the current year.

I personally wish that they took into account where you lived.  My wife and I aren't qualified but it doesn't mean we're too rich to avail of Roth IRA.  We live in an area where houses are expensive and the cost of living is high.  It should be factored into the contribution calculations somehow.

As you may have realized, the time to contribute to Roth IRA is when your income is still below the threshold.  Strike while you can.

But wait, I see a backdoor!

There is a workaround to this income-based limitation.  You can convert Traditional IRA funds into Roth IRA.  Tadaa!

There are no limits to how much you can convert.  People would open a Traditional IRA or fund an existing one, and then immediately convert the funds to Roth.  This is called the backdoor Roth IRA.

The catch is, you will need to pay tax on any funds that you hadn't paid tax on, which would be the earnings and any pre-tax contributions.  It's just fair, IMO.

It gets tricky though if you have multiple IRA accounts.  You're supposed to treat them as one big IRA account and figure out how much of it is pre-tax and how much is post-tax.  Let's say you figured out that 90% is pre-tax and only 10% is post-tax.  Whatever amount you convert, 90% of that will be taxed, even if you're getting all the funds from a non-deductible Traditional IRA (meaning, all post-tax contributions).  I know it's weird.  And my understanding may not be 100% correct.  You would definitely want to consult your tax accountant on this one.

There were talks in 2016 about possibly eradicating backdoor Roth IRA.  Unless it's been done, you may want to take action now'ish if you're planning on it.

Some employees have all the luck!

Some employers offer a Roth 401(k).  There are no income limits and you can contribute as much as you would to a regular 401(k).  My previous employer offered it.  And I was able to roll it over into a Roth IRA afterwards.

Some employers also allow after-tax contributions to a regular 401(k).  It's not Roth.  The earnings from these contributions will still be taxed in the end.  However, you can roll over your after-tax contributions to a Roth IRA when you leave the company.  I've read that some companies even allow in-service withdrawals. Meaning, you can roll them over into a Roth IRA whenever.  But I have yet to look into the mechanics.

You should definitely check if your employer offers any of the above.

Business owners, don't fret!

I happen to be one, too and I'm beating myself up for not knowing about this until just recently.  There is this thing called Solo 401(k) that was created for employers with no full-time employees besides themselves and their spouse.  I am a sole proprietor.  I recently opened an Individual 401(k) account with E*Trade (that's what they call them) because theirs offers a Roth option.  Not all financial institutions do.

You can contribute both as an employer and as an employee.  The employee portion can be either pre- or post-tax (Roth).  As you may have guessed, I opened the account largely to take advantage of the ability to make Roth contributions.  There is also a limit to how much you can contribute but it's more generous than that for Roth IRA. 

If you're a business owner, you should definitely check out Solo 401(k) if you haven't.

There you have it, folks.  This is just a preview of the greatness that is Roth.  I may go into details in later posts but for now,  I trust that you will move on to other sources of information.

Then, you can trust your informed gut. :)

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